UK small caps ripe for recovery

Though, with a recession looming, an entry point will be tough to pinpoint

apple
Photo by Erika Fletcher on Unsplash

|

It has been a grim year for investors in UK smaller companies. With the exception of China and technology, it has been the worst performing equity sector over one year, with the average fund down 22.7%. While cheap valuations leave the sector looking ripe for a recovery, it will almost certainly need to face down a recession in 2023.

As might be expected in a climate of weaker economic growth, risk aversion, and rising interest rates, smaller companies across the world have done badly in 2022 and UK smaller companies are at the bottom of the heap. Sentiment has been weak even if, operationally, companies have continued to thrive.

David Taylor, manager of the Chelverton UK Equity Income fund, admits that this year has felt like being on the downward slope of a rollercoaster, but adds: “The one thing that has been quite remarkable is that smaller companies in the UK have surplus capital and have rebuilt dividends. It is a strange situation where the world appears to be falling apart around our ears, and a lot of people are selling UK assets, but a lot of our companies are holding up well in terms of dividends and cash flows, even if share prices have fallen.”

He points out that more companies are buying their own shares back than at any point in his history of running the fund. He adds: “To have the confidence in the cash flows to buy your own shares back is quite something.”

Nevertheless, a recession in the UK now appears to be inevitable. In November, UK economic activity shrunk for a fourth consecutive month and the Bank of England is now predicting a lengthy period of contraction for the UK economy. While UK smaller companies draw more revenues from overseas than many believe, they are undoubtedly more domestically focussed than larger companies.

Anna Macdonald, fund manager at Amati Global Investors, says that against this backdrop there are obvious areas to avoid among UK smaller companies: “Anything with a high exposure to energy, or to rising labour costs – such as retail and hospitality – is going to be tricky.” Even some technology companies may be affected by higher wage bills. If investors are going to delve into these sectors, they have to be very selective. She gives the example of pub group Young and Co, which has hedged its energy costs to 2024 and is exposed to a more affluent consumer. MJ Gleeson may prove strong even though the outlook for the wider housing sector looks grim.

The team at Amati has altered the portfolio quite considerably since the spectre of inflation emerged, taking profits in higher valued growth companies. “We wanted to be in the really good names.” They have also taken some strategic positions in companies likely to benefit from a recession, such as insolvency specialist Begbies Traynor.

“The companies that we invest in tend to be asset-light, enabling them to deliver higher margins. This gives them an economic moat. They will often have intellectual property that allows them to protect margins.”

At the same time, cash is vitally important. Without cash, companies can’t pay dividends or take advantage of the weakness of competitors. Equally, debt is a significant problem and could leave companies vulnerable to insolvency as borrowing costs rise. While there is often a ‘dash for trash’ rally at the start of a new economic cycle, it appears too early to predict that now.

Both Taylor and Macdonald believe that there is real value in UK smaller companies today. In the investment trust sector, for example, discounts are still below their historic averages in spite of a recovery over the past month. The Abrdn UK Smaller Companies Growth trust is currently on an 11% discount, compared to a 12-month average of 8%, the Invesco Perpetual UK Smaller Companies trust is on a 15% discount, compared to a 12-month average of 11%. If the sector turned, investors could see a significant bounce.

However, managers in the sector admit that predicting the point at which the outflows stop and sentiment turns is very difficult. Taylor says: “There are times in the market when growth gets very over-rated and cash flows are under-rated. That’s where we are now. It won’t be investors that will start the recovery, but instead, you will see corporates buying. We’ve got some great companies trading at very low multiples and international corporates recognise that. The value will be realised at some point, but it’s difficult to know when.” Macdonald agrees the sector has seen encouraging bid activity: “A lot of overseas companies know they are getting in at a good price.”

For smaller companies, the impact of sterling has been a relative detractor. While it has made the companies more appealing to foreign bidders, in general they haven’t had the flattering effect of international cash flows translated back into sterling. This means earnings have looked lower, in aggregate, relative to larger companies with significant overseas revenues. There has been some recovery in sterling versus the dollar since the end of September and this may change the relative performance of smaller companies.

Investors in smaller companies are stuck in a holding pattern. There is obvious value in the sector and history suggests that the bounce will be strong when it comes. However, share prices could continue to weaken as recession bites and there may be better opportunities to buy ahead. The perils of trying to time the market are well-documented. Investors may have to invest and then shut their eyes for 12 months.

See Also: Is the 60/40 portfolio about to make a comeback?